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How to Understand an Income Statement: Part 1

In this article, I will share a few things you need to know about income statements so that you can interpret them easily.

Income Statement is also known as the Profit and Loss Statement

An income statement tells you how much money the company is making or losing in a single period. If you are reading an income statement from a company’s annual report, the period is usually set at 12 months, unless it is stated otherwise. If you are reading it from the quarterly report, the period is set at three months.

The income statement reports profits generated from a company’s operating activities and non-operating activities.

What are Operating Activities?  

It is profits or expenses from a business operation. It is formulated with the equation below:

Sales – Operating Expenses = Operating Profits

I believe the term ‘sales’ is self-explanatory. So, what are operating expenses? To name a few, these expenses include the cost of raw materials, overheads, rents, utilities, distributions, promotions, marketing, administrations and so on.

In brief, they are transactions which are associated with the operations of the business.

What are Non-Operating Activities?

It is profits or expenses which are not associated with the business operations.

To name a few, they include interest income and expenses, taxes, foreign exchange gains or losses, investment gains or losses, and gains from disposal of a stock’s assets such as plants, properties, equipment, subsidiaries, associates, and joint venture companies.

In brief, they are transactions which are not associated with the operations of the business.

What are Shareholders’ Earnings?

If you combine both transactions from operating and non-operating activities, you would have shareholders’ earnings over a period. The formula is as follows:

Shareholders’ Earnings = Operating Profits + Gains or Losses from Non-Operating Activities

So, how do I know whether a company is truly profitable?

It is simple. I look at a company’s reported sales, operating profits and shareholders’ earnings. The three figures must be positive figures to confirm that a firm is truly profitable over a certain period.

Now, here are two questions:

a) What if both sales and operating profits are positive figures and the figure of shareholders’ earnings is negative?

Answer: The company is not profitable.

b) What if both sales and shareholders’ earnings are positive figures and the figure of operating profits is negative?

Answer: This is often a red flag that prompts investors to investigate further if they are interested in investing in the company. After all, the objective of an investor is to make recurring profits year after year from investing in a stock. The stock may be a bad investment if it relies heavily on gains from non-operating activities to make money for shareholders.

The Foolish Summary

I’ve just covered the broad strokes but the article still provides a good introduction to what an income statement is and how you can detect a stock that is truly profitable from one that is not.

If you are new to financial statements, there is a lot more to learn and master when it comes to the art of interpreting financial statements. Don’t be discouraged, though; take it one step at a time.

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Editor's Note: The title has been amended to show that this article is part one of a two-part series. Part two of the series has been published and it can be found here.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.